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Finding No “Therapeutic” Benefit to Corporation, Court Denies Fee Award in Discontinued Shareholder Derivative Action

June 05, 2017

Therapy1At first glance, you might think the plaintiff minority shareholder in Sardis v Sardis, 2017 NY Slip Op 27163 [Sup Ct Suffolk County May 11, 2017], achieved her derivative lawsuit’s goal when the defendant controlling shareholder, about a month after suit was filed, suddenly reversed course by revoking the corporation’s allegedly wrongful voluntary dissolution that seemingly was the lawsuit’s raison d’être.

You might also think, having apparently forced defendant’s capitulation, the minority shareholder would be entitled to recover her legal fees in the action as authorized by Section 626 (e) of the Business Corporation Law whenever a shareholder derivative action “was successful, in whole or in part, or if anything was received by the plaintiff . . . as a result of the judgment, compromise, or settlement of an action or claim.”

But, as often is the case in shareholder lawsuits, first impressions can be deceptive.

The Sardis case, in which Suffolk County Commercial Division Justice Elizabeth H. Emerson denied the plaintiff’s fee application seeking $650,000, is noteworthy for a couple of reasons. First, the facts and circumstances leading up to the decision — starting with the settlement of a complex matrimonial divorce in which the ex-spouses continued to co-own interests in a valuable operating company, followed by legal proceedings in Delaware, followed by legal proceedings in New York — tell a fascinating story of a high-stakes, three-dimensional legal chess game.

Second, and more importantly for practitioners, Justice Emerson’s opinion is one of the very few New York state court decisions that takes a probing look at the prevailing “substantial benefit” standard for an award of legal fees under Section 626 (e).

Background

The plaintiff Lauren Sardis and defendant Jeffrey Sardis, who were married, divorced in 2009. Their 2008 divorce settlement included a Stockholders Agreement for their Delaware holding company known as JLAJ owned 67% by Jeffrey and 33% by Lauren. The Stockholders Agreement designated Jeffrey president and sole director. The holding company’s sole asset is its wholly-owned operating subsidiary, also incorporated in Delaware, known as AETEA which provides IT consulting services to Fortune 500 companies. A second Delaware holding company known as SCCC owned 40/40/20 by Jeffrey, Lauren, and a trust for the benefit of their children owns as its sole asset a promissory note by AETEA with a balance of $16 million including accrued interest.

The divorce settlement provided for Lauren to receive from JLAJ annual distributions of $300,000 in lieu of maintenance, and for Jeffrey to be paid an annual salary of $500,000. The agreement also required Jeffrey to use commercially reasonable efforts to sell the shares or assets of JLAJ and AETEA, and incentivized him to do so by reducing his salary to zero by September 2014 if no transaction occurred by September 2012. The agreement also defined an “Approved Sale,” which did not require Lauren’s consent, as an “arms-length” transaction excepting any transaction with an affiliate or family member of Jeffrey.

In April 2014, there having been no such transaction, and without prior notice to Lauren, Jeffrey as AETEA’s sole director adopted a resolution authorizing him to file a certificate of dissolution of AETEA and to distribute its assets pursuant to a Plan of Liquidation and Dissolution which allowed, but did not require, AETEA to pay Jeffrey compensation to implement the Plan. Next, that same month, Jeffrey filed a petition in Delaware Chancery Court for appointment of an independent receiver to oversee AETEA’s winding up and liquidation including an auction sale of its assets. His petition disclosed his own interest in purchasing AETEA’s assets.

Lauren responded with a two-pronged legal challenge. First, she intervened in the Delaware proceeding to oppose both the dissolution of AETEA and the appointment of a receiver, claiming that those actions violated provisions in the divorce settlement and the restrictions on non-Approved Sales in the 2008 Stockholders Agreement.

Second, in January 2015 she filed a complaint in New York state court asserting direct and derivative claims for breach of contract and breach of fiduciary duty, based on various alleged violations of, and defaults under, the divorce settlement and Stockholders Agreement by reason of Jeffrey’s dissolution of AETEA and receivership petition.

Then came Jeffrey’s turnabout. A little over a month after Lauren filed her New York action, and two days before Jeffrey filed his answer to her complaint, Jeffrey filed a certificate in Delaware revoking the dissolution of AETEA and reinstating it as a corporation, following which he moved in Delaware to discontinue that proceeding. In July 2015, the Delaware case was discontinued by stipulation under which Jeffrey reimbursed Lauren $175,000 for her legal fees in that case.

About eight months later, in March 2016, Lauren and Jeffrey entered into a so-ordered stipulation discontinuing the New York action conditioned on Lauren’s right to apply to the court for an award of legal fees based on both BCL Section 626 (e) and on a provision in the divorce agreement authorizing a fee award against a defaulting party.

The Court’s Denial of Lauren’s Fee Application

Lauren initially moved for a fee award in April 2016, which Justice Emerson denied in a two-page Short Form Order in September 2016. Lauren subsequently moved to reargue that decision, leading to last month’s lengthier and more interesting decision granting reargument but adhering to the court’s prior ruling denying fees based both on the claimed defaults under the divorce settlement and on Section 626 (e).

I’m only going to address Justice Emerson’s Section 626 (e) analysis which begins with a highly instructive summary of the “substantial-benefit” rule at the heart of what it means to be “successful” under the statute:

As Lauren correctly contends, the creation of a common fund is no longer a prerequisite to an award of attorney’s fees pursuant to Business Corporation Law § 626 (e). New York follows the substantial-benefit rule articulated in a series of federal cases which hold that attorney’s fees are recoverable, even in the absence of a common fund, when the plaintiff has achieved a “substantial benefit” accruing to the corporation and the other shareholders. The benefit need not be a tangible monetary benefit. Non-monetary benefits resulting from the plaintiff’s suit, such as promoting fair and informed corporate suffrage or deterring future misconduct by management, may support a fee award. Moreover, an award of attorney’s fees is not precluded because no judgment or consent decree was entered and the complaint was dismissed as moot. Fees may be awarded even when there is no judgment on the merits or when the dispute has become moot because the relief sought has been otherwise obtained. . . .

The term “substantial benefit” requires more than a mere technical act. It must actually accomplish a result that corrects a wrong that would, inter alia, interfere with the protection of essential rights of the shareholders (Matter of Medical Action Indus. Inc. Shareholders Litig., 48 Misc 3d 544, 549, citing Mills v Electric Auto-Lite Co., 396 US 375, 396). As previously noted, promoting fair and informed corporate suffrage or deterring future misconduct by management may support an award of attorney’s fees. Similarly, awards of attorney’s fees have been based on protection of the corporate name and improved disclosure. In the cases in which attorney’s fees have been awarded, the petitioners have rendered a substantial service to the corporation and its shareholders. They involve “corporate therapeutics” that benefit the corporation and all of its shareholders, not just one class of shareholders. In such cases, an award of attorney’s fees is appropriate to avoid unjust enrichment. To allow others to obtain full benefit from the plaintiff’s efforts without contributing equally to the litigation expenses would be to enrich the others unjustly at the plaintiff’s expense. [Some citations omitted.]

Lauren contended that her lawsuit conferred a substantial benefit because it caused Jeffrey to take corrective action and that, “by abandoning his plan to dissolve AETEA and to liquidate its assets, JLAJ retained its sole source of income and its ability to pay the SCCC Note.” She also contended that “but for” her derivative suit, “Jeffrey would have sold AETEA’s assets to himself, terminated the distributions in lieu of maintenance to her, circumvented the reduction of his salary to zero, and impaired repayment of the SCCC Note, all of which violate the . . . Stockholders Agreement.”

Justice Emerson not only disagreed with Lauren’s contentions, she implied that Lauren’s litigation effort was designed solely for her own benefit. Here’s what the judge wrote:

Lauren’s contentions to the contrary notwithstanding, this action did not involve “corporate therapeutics,” and the only shareholder who benefitted therefrom is Lauren. As previously discussed, Lauren has failed to establish that Jeffrey breached terms of the Stipulation of Settlement and Stockholders Agreement. Those agreements did not prohibit AETEA’s dissolution and liquidation by a receiver appointed to supervise the process. In fact, they anticipated that AETEA would be sold and that JLAJ would be dissolved and liquidated shortly thereafter. Lauren was given notice of the Delaware proceeding and intervened therein. Her intervention gave her an opportunity to oppose any sale of AETEA to Jeffrey, ensuring that the process would be fair. Moreover, the Plan of Liquidation and Dissolution adopted by Jeffrey provided for the payment of AETEA’s creditors, which included SCCC, in accordance with Delaware law (see, 8 Del C §§ 280-28). The court finds that, under these circumstances, this action did not result in a substantial benefit to JLAJ or SCCC and their stockholders. It merely delayed the anticipated sale of AETEA and allowed Lauren to continue to receive disbursements in lieu of maintenance. Accordingly, the court adheres to its prior determination that Lauren is not entitled to attorney’s fees under Business Corporation Law § 626 (e).

Lawsuits of this sort involving close corporations with a small number of shareholders more often than not include a mix of both individual and direct claims, some of which may overlap in terms of the wrongful conduct alleged and the relief sought which, as in Sardis, can muddy the plaintiff’s claimed entitlement to fees under Section 626 (e) when the case terminates short of an adjudication on the merits of the claims. This was not the plaintiff’s only problem in Sardis, but when combined with the facts that (1) she was reimbursed $175,000 for fees in the Delaware action and (2) Jeffrey revoked the dissolution promptly after the filing of the derivative action, it’s not hard to understand the outcome of her subsequent request for an additional $650,000 in fees.